The global economy, particularly in North America, was slowly building positive momentum up to the end of August. Gross domestic product and jobs were growing (although with big differences among and between regions). Equity markets had a long positive run, recovering the ground lost during the 2008 financial crisis and aftermath. And then something happened and everyone is running for the hills.
What has actually changed over the past six weeks? The facts have slightly shifted; investor psychology changed a lot – and the latter has driven financial market behaviour.
On the facts, the Conference Board of Canada would point to a number of specific economic factors. Importantly, the weak recovery in Europe has lost steam. The combination of fiscal austerity – designed to get deficits and debt under control – and inadequate progress on structural policies that would encourage growth has prevented the formation of a foundation for recovery. Growth in France is painfully weak, Italy has slipped back into recession and other economies are waning. Even Germany, which had led the European Union recovery, saw a contraction of industrial output in the second quarter due to weakened demand for German exports from its EU trading partners and Russia. A number of emerging markets such as Brazil, India and, of course, Russia have seen slippage in their growth performance.
In addition, rising global oil production coupled with stagnant consumption led to a buildup in inventories. Global oil prices have quickly adjusted to this fundamental short-term imbalance, pulling down the profit expectations for oil producers and their key suppliers. Finally, the U.S. Federal Reserve has been steadily withdrawing its exceptional quantitative easing (QE), anticipating that the U.S. economic recovery could be sustained without this "monetary morphine" – but raising concerns on whether America was fully ready to go it alone.
These are real and measurable forces; but arguably the more important factor for financial markets over the past six weeks has been psychological. Perceived geopolitical risks in Ukraine and the Middle East had risen over a number of months, and the emergence of the Islamic State militants as a regional threat has pushed the fear factor to an even higher level. The spread of Ebola, real and imagined, has simply added to the existing fear. Moreover, financial markets have taken a closer look at the EU and realized that the strategy to manage excessive levels of public debt in many southern EU countries had not advanced.
When the two real economic factors are combined with the rising psychological alarm, the result has been a sudden shift in market perception from positive to sharply negative. Equity markets have fallen by 10 per cent or more; debt markets have adjusted quickly as investors "de-risked" their portfolios, with a rapid downward shift in interest rates on longer-term bonds.
Has anything been missed in this rush to de-risk, driven by the psychological fear factor? Two positive economic factors deserve more weight. First and most importantly, all available evidence points toward a recovery in the U.S. economy that is real and sustainable, driven by the private sector and notwithstanding the withdrawal of QE. The U.S. recovery provides the global economy with a solid cornerstone (representing about 25 per cent of global GDP) that has not been this strong since 2007. The profitability of U.S. firms is largely based on the recovery in domestic demand, which ultimately will underpin U.S. equity and debt markets.
Second, the rapid shift to sharply lower oil prices is obviously bad for oil producers and their suppliers, but is good for consumers almost everywhere – as well as businesses that use oil-based products. As we spend less on oil, consumers and businesses will have more cash available to spend on other goods and services, likely improving their overall consumer and business satisfaction and confidence. Sustained lower oil prices will also dampen production by high-cost suppliers, helping to correct the existing oil overstock, and will discourage the oil industry from pursuing some planned new investment projects. Over all, lower oil prices are a net positive for the global economy.
The Conference Board's view is that emotion has amplified the downward financial market impact of a few real negative economic factors. But there are also some positive economic forces at work, notably the U.S. recovery and the benefit of lower oil prices for consumers, which may have been underappreciated. If you form your views based on the underlying economic trends, keep calm and carry on.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada.